Is Ripple (XRP) a Security?
Is Ripple (XRP) a security? That’s a big question right now in the crypto community.
The Securities and Exchange Commission (SEC) recently provided guidance on how the SEC will approach cryptocurrency regulation.
The Ethereum Community was relieved to hear that Ether (ETH), the native cryptocurrency on the Ethereum network, would NOT be considered a security. A similar SEC approach to Ripple (XRP) would be welcomed by the XRP Community, yet XRP wasn’t specifically mentioned. Therefore the regulatory status of XRP remains in question.
Emotions run amuck when the crypto community discusses Ripple (XRP). It gets heated. Many market participants see Ripple (XRP) as a centralized corporate affront to the cryptocurrency revolution. Others see XRP as a scalable solution with a real world use case.
XRP is the native crypto asset used on the XRP Ledger. Ripple, a private company, uses XRP exclusively in its xRapid product and owns a significant amount of XRP. xRapid facilitates faster settlement of cross-border payments, amongst other payment use cases. As one delves into the close relationship between Ripple and XRP, the lines become blurry.
Analysis by commentators on both sides of the debate is clouded by bias when trying to answer whether Ripple is peddling an unregistered security.
Over the past week we have heard many commentators implying that given the new SEC guidance Ripple XRP is unquestionably a security. In our own analysis we see a less obvious conclusion.
Source: Twitter
Source: Twitter
Is Ripple XRP a Security?
No one really knows the answer to this question until the SEC or courts make the final decision. Yet we can gather insights from the SEC’s guidance. An SEC determination would hold significant weight in court. Ripple is currently being sued for securities law violations. In prepared remarks entitled, “Digital Asset Transactions: When Howey Met Gary (Plastic)”, the SEC’s William Hinman provided a broad framework meant to steer the emerging crypto asset market into compliance. Studying this document, line by line, can provide us with a rough probability of whether XRP is a security.
We broke the document down by paragraph, starting at paragraph 1 and ending at paragraph 19. After paragraph 19 the document shifted from a narrative into a more question and answer format. We used a simple point system, assigning equal weight to each relevant section. Using this approach we arrived at the probability of the SEC determining XRP a security or not.
Two sections follow below, one assigning points for XRP being a security and another assigning points for XRP NOT being a security.
XRP is a Security (Total Points: 14)
Language in narrative section supporting points awarded:
(Paragraph #6) Promoters, in order to raise money to develop networks on which digital assets will operate, often sell the tokens or coins rather than sell shares, issue notes or obtain bank financing. But, in many cases, the economic substance is the same as a conventional securities offering. Funds are raised with the expectation that the promoters will build their system and investors can earn a return on the instrument — usually by selling their tokens in the secondary market once the promoters create something of value with the proceeds and the value of the digital enterprise increases. — Analysis: Ripple is most likely seen as the promoter.
(Paragraph #8) …tokens and coins typically are sold to a wide audience rather than to persons who are likely to use them on the network. — Analysis: XRP tokens are being sold on secondary exchanges to non-users.
(Paragraph #9) Like in Howey, the investors are passive. — Analysis: True, but also true for most Bitcoin and Ethereum investors at this stage. We are taking this statement at face value and assigning the point to the “XRP is a Security” category. This was the source of much internal debate.
(Paragraph #9) …the purchase of a token looks a lot like a bet on the success of the enterprise and not the purchase of something used to exchange for goods or services on the network. — Analysis: Ripple’s xRapid product is the largest driver of XRP adoption, although other use cases are emerging.
(Paragraph #15) If the network on which the token or coin is to function is sufficiently decentralized — where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts — the assets may not represent an investment contract — Analysis: Debatable but XRP is much more centralized than other projects. This centralization has positive attributes, but may hurt XRP when seeking to not be regulated as a security.
Questions and Answers section supporting points awarded:
Is there a person or group that has sponsored or promoted the creation and sale of the digital asset, the efforts of whom play a significant role in the development and maintenance of the asset and its potential increase in value? Yes
Has this person or group retained a stake or other interest in the digital asset such that it would be motivated to expend efforts to cause an increase in value in the digital asset? Would purchasers reasonably believe such efforts will be undertaken and may result in a return on their investment in the digital asset? Yes
Has the promoter raised an amount of funds in excess of what may be needed to establish a functional network, and, if so, has it indicated how those funds may be used to support the value of the tokens or to increase the value of the enterprise? Does the promoter continue to expend funds from proceeds or operations to enhance the functionality and/or value of the system within which the tokens operate? Yes
Are purchasers “investing,” that is seeking a return? Yes
Do informational asymmetries exist between the promoters and potential purchasers/investors in the digital asset? Yes
Do persons or entities other than the promoter exercise governance rights or meaningful influence? Not really.
Are independent actors setting the price or is the promoter supporting the secondary market for the asset or otherwise influencing trading? Despite the XRP escrow account established by Ripple, the mechanism for Ripple to influence prices in secondary markets still exists. As an aside, Bitcoin has a highly concentrated ownership which most definitely can affect prices.
Are there built-in incentives that compel using the tokens promptly on the network, such as having the tokens degrade in value over time, or can the tokens be held for extended periods for investment? No, there is no inflationary mechanism.
Are the assets dispersed across a diverse user base or concentrated in the hands of a few that can exert influence over the application? There is significant concentration of XRP at Ripple.
XRP is NOT a Security (Total Points: 13)
Language in narrative section supporting points awarded:
(Paragraph #6) Promoters, in order to raise money to develop networks on which digital assets will operate, often sell the tokens or coins rather than sell shares, issue notes or obtain bank financing. But, in many cases, the economic substance is the same as a conventional securities offering. Funds are raised with the expectation that the promoters will build their system and investors can earn a return on the instrument — usually by selling their tokens in the secondary market once the promoters create something of value with the proceeds and the value of the digital enterprise increases. — Analysis: Focusing on language surrounding the status of development. The SEC seems to make a distinction between developed and developing “systems”. XRP is not under development.
(Paragraph #10) As an aside, you might ask, given that these token sales often look like securities offerings, why are the promoters choosing to package the investment as a coin or token offering? This is an especially good question if the network on which the token or coin will function is not yet operational. — Analysis: XRP is operational.
(Paragraph #12) I believe some industry participants are beginning to realize that, in some circumstances, it might be easier to start a blockchain-based enterprise in a more conventional way. In other words, conduct the initial funding through a registered or exempt equity or debt offering and, once the network is up and running, distribute or offer blockchain-based tokens or coins to participants who need the functionality the network and the digital assets offer. This allows the tokens or coins to be structured and offered in a way where it is evident that purchasers are not making an investment in the development of the enterprise. — Analysis: Ripple raised funds through traditional venture capital, it was not solely funded via an ICO.
(Paragraph #15) Moreover, when the efforts of the third party are no longer a key factor for determining the enterprise’s success, material information asymmetries recede. As a network becomes truly decentralized, the ability to identify an issuer or promoter to make the requisite disclosures becomes difficult, and less meaningful. — Analysis: Ripple disclosing required information to the SEC is becoming less relevent as the XRP ecosystem grows (i.e. Codius, Coil).
Questions and Answers section supporting points awarded:
Is the instrument marketed and sold to the general public instead of to potential users of the network for a price that reasonably correlates with the market value of the good or service in the network? Focusing on “marketed”, we believe Ripple is marketing to potential users of XRP, not speculators.
Does application of the Securities Act protections make sense? Is there a person or entity others are relying on that plays a key role in the profit-making of the enterprise such that disclosure of their activities and plans would be important to investors? Debatable, but we do not see how Ripple making required SEC disclosures would necessarily be to XRP’s benefit. If Ripple filed for an IPO then it would make those disclosures for the benefit of Ripple shareholders, not XRP holders.
Is token creation commensurate with meeting the needs of users or, rather, with feeding speculation? Yes, users are payment processors and banks who are targeted for Ripple’s xRapid product which actively uses XRP.
Is it clear that the primary motivation for purchasing the digital asset is for personal use or consumption, as compared to investment? Banks and payment processors are the target user/consumer of XRP.
Have purchasers made representations as to their consumptive, as opposed to their investment, intent? Several banks have announced successful xRapid pilots.
Are the tokens available in increments that correlate with a consumptive versus investment intent? Yes
Are the tokens distributed in ways to meet users’ needs? Yes
Is the asset marketed and distributed to potential users or the general public? Ripple markets to potential users.
Is the application fully functioning or in early stages of development? XRP is fully functioning although the ecosystem is expanding into new use cases.
In Summary
Although the “XRP is a Security” column accumulated more points, the victory is slight and within the margin of error. It was interesting that the SEC made a distinction between developed systems and developing systems. In fact, this was mentioned or alluded to ten times in the guiding document. If the SEC is assigning more weight to developed systems not being securities then that would be significant. We think this is very possible.
The SEC is likely to go after the “low hanging fruit” first. So obvious scammers should be more concerned about the SEC than XRP investors. In the meantime, we are confident Ripple will use the SEC’s guidance to further enhance the viability of XRP as a digital asset and not a security.
Commentators should be slower to declare XRP a security.
Invest Savagely.
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